Play a Snap-Back in Small Caps

by Tyler Craig | September 19, 2012 9:29 am

After a furious high-volume charge late last week, the bulls have taken a well-deserved rest in Monday and Tuesday’s trading sessions.

The two-day retreat from Friday’s fresh bull market high has come on light volume — a sign that major selling pressure is absent. All the while, volatility has been muted with the past two trading days staying contained within a narrow trading range, particularly in the Nasdaq Composite Index.

This kind of price action could properly be characterized as the digestion of recent gains, a mere pause in the ongoing uptrend. With the market gods still smiling on the bulls, any and all pullbacks should be viewed as buyable events.

Given the behavior of the market in recent days, traders should be able to find a litany of these pullbacks in virtually all sectors of the market. One that I’m eying with particular interest is the Russell 2000 Index (RUT), which is a great proxy for small-cap stocks.

Click to Enlarge The bout of relative strength mentioned in my recent article[1] has continued over the past few weeks. As shown in the accompanying chart, the Comparative Relative Strength (green line) continues to rise.

Traders willing to bet the path of least resistance for small caps remains higher might consider selling the October 810-800 bull put spread for $1.10 credit or better.

If RUT remains above $810 by October expiration, the put spread will expire out-of-the-money, allowing you to capture the entire $110 credit. The max risk is limited to the distance between strike prices minus the net credit, or $8.90 (10 – 1.10). To minimize the loss, however, you could exit the trade if RUT falls beneath the short strike price (810). With the early exit, your managed risk is closer to $250 or so.